Microeconomics

• 1. Introduction

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  Microeconomics studies the behavior of individuals and firms as they make decisions about scarce resources. It is the close-up lens of economics, fixed on single markets, sectors, and industries rather than the whole economy. That wider view belongs to macroeconomics, which weighs growth, inflation, and unemployment.

  The distinction sounds tidy, but it was not always there. The split between the two was likely introduced in 1933, and the word itself arrived later still. Behind that vocabulary sits a stranger ambition. Economists wanted to explain not only what choices people make, but why they make them at all.

  How does a market mechanism settle on a price? When do free markets reach desirable outcomes, and when do they fail? What does it cost to choose chocolate over waffles? These are the questions the rest of this story will work through, one assumption at a time.

• 2. The Birth Of A Word

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  In 1933, the Norwegian economist Ragnar Frisch likely introduced the difference between microeconomics and macroeconomics. He never actually used the word "microeconomics". Instead he drew a line between "micro-dynamic" and "macro-dynamic" analysis, in a way that matches how the two terms are used today.

  Frisch went on to become the co-recipient of the first Nobel Memorial Prize in Economic Sciences in 1969. The award honored a thinker who had helped split economics into its two great halves before either half had its modern name.

  The term "microeconomics" first appeared in a published article in 1941, written by Pieter de Wolff. De Wolff took the existing idea of "micro-dynamics" and broadened it into the word that now anchors an entire branch of the field.

• 3. The Rational Chooser

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  Microeconomic theory typically begins with a single rational, utility-maximizing individual. To economists, rationality has a precise meaning. It is the possession of stable preferences that are both complete and transitive.

  General equilibrium theory gave this approach its foundation. It was developed by Léon Walras in Elements of Pure Economics, published in 1874. Partial equilibrium theory came later, introduced by Alfred Marshall in Principles of Economics in 1890.

  Building the theory takes a chain of careful assumptions. Continuous preference relations are needed to guarantee that a utility function exists. The assumption of local non-satiation, abbreviated LNS, helps ensure a rational increase in individual utility. Out of these pieces comes the utility maximization problem, or UMP.

  The utility maximization problem is the heart of consumer theory. It models an individual seeking to maximize utility subject to a budget constraint. Economists lean on the extreme value theorem to prove a solution exists, since the budget constraint is both bounded and closed. They call that solution a Walrasian demand function or correspondence. An alternative path takes consumer choice rather than tastes as primitive, an approach known as revealed preference theory.

• 4. How Prices Find Their Level

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  Supply and demand is the model of price determination in a perfectly competitive market. In such a market, with no externalities, per-unit taxes, or price controls, the unit price settles where the quantity demanded equals the quantity supplied. That point is a stable economic equilibrium.

  The law of demand says price and quantity demanded are generally inversely related. As a commodity gets cheaper, consumers shift toward it from pricier goods, a shift called the substitution effect. The falling price also boosts purchasing power, the income effect. A rise in income shifts the demand curve for a normal good outward.

  Producers are hypothesized to be profit maximizers. The Law of Supply holds that a rise in price expands supply and a fall in price contracts it, because a higher price makes increased production profitable. Below the equilibrium price, a shortage bids the price up. Above it, a surplus pushes the price down.

  At equilibrium in a perfectly competitive market, supply and demand equate marginal cost and marginal utility. For the consumer, the most-preferred position is where marginal utility net of price reaches zero. For the producer, output stops where marginal profit reaches zero. These changes happen "at the margin": more or less of something, rather than all or nothing. The same framework reaches into factor markets, where the wage rate depends on the demand for and supply of labor.

• 5. What Things Really Cost

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  The cost-of-production theory of value holds that an object's price is set by the sum of the resources that went into making it. Those resources can include any of the factors of production, such as labor, capital, or land, plus taxation. Technology can count as fixed capital, like an industrial plant, or as circulating capital, like intermediate goods.

  Fixed cost does not change with output. It covers expenses such as rent, salaries, and utility bills. Variable cost changes as output changes, taking in raw materials, delivery costs, and production supplies. Over a few months, most costs stay fixed. Over 2-3 years they can become variable, as firms cut output or sell machinery. Over ten years, most costs turn variable, as workers can be laid off and old machinery replaced.

  Sunk costs are fixed costs already incurred and impossible to recover. Research and development in the pharmaceutical industry shows the danger. Hundreds of millions of dollars chase new drug breakthroughs, which grow harder to find under tighter regulatory standards. Many projects get written off, costing millions.

  Opportunity cost is the value of the next-best alternative given up. It depends only on that single next-best option, whether one faces five alternatives or 5,000. The classic illustration is a choice between waffles and chocolate. If chocolate is preferred, the opportunity cost of eating waffles is the chance to eat chocolate. The duality theory in economics, which characterizes production through cost functions, was developed mainly by Ronald Shephard in 1953 and 1970.

• 6. The Many Shapes Of A Market

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  Market structure describes the features of a market: the number of firms, the distribution of market shares, how uniform products are, and how easily firms can enter and exit. These features sort markets into distinct types, each producing its own cost curves.

  Perfect competition pits numerous small firms making identical products against one another. They produce the socially optimal output at the minimum possible cost per unit, and they are "price takers" with no power to raise prices profitably. Digital marketplaces such as eBay, where many sellers offer similar products to many buyers, fit the picture. Consumers there are assumed to have perfect knowledge of the products.

  Imperfect competition sits between the extremes. Firms such as Pepsi, Coke, Sony, Nintendo, and Microsoft dominate the cola and video game industries. A monopoly is a single supplier dominating a market, charging higher prices and producing below the socially optimal level. Some monopolies are natural, arising where one producer can produce at a lower cost than many small ones.

  The family of structures stretches further. Monopolistic competition has many firms with slightly different products, seen in restaurants, cereal, clothing, and shoes. An oligopoly is dominated by a few firms, who may collude and form cartels. A monopsony has one buyer and many sellers, like a mining town where the company sets wages low because workers cannot easily leave. A bilateral monopoly combines a single seller and a single buyer.

• 7. When Markets Fail

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  Mainstream economics does not assume in advance that markets beat every other form of social organization. Much of its analysis is devoted to market failure, where resource allocation turns out suboptimal and creates deadweight loss. The classic example is a public good.

  Facing such failures, economists search for policies that avoid waste. They may use direct government control, regulation that nudges participants toward optimal welfare, or the creation of "missing markets" where none existed before. This work falls within collective action and public choice theory. "Optimal welfare" usually rests on a Paretian norm, a mathematical application of the Kaldor-Hicks method, which can diverge from the Utilitarian goal because it ignores how goods are distributed.

  Competition acts as a regulatory mechanism, with government stepping in where the market cannot self-regulate. Building codes are a telling case. Without them, a purely competition-regulated system might allow horrific injuries or deaths before firms improved structural safety, since companies would resist safety features that cut into profits.

  Governments are not the only allocators. In the former Soviet Union, the state told car manufacturers which cars to produce and decided which consumers could get them. That example marks the far end of a spectrum that runs all the way to consumers and firms choosing entirely on their own.

• 8. Tools And Frontiers

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  Game theory is a major method for modeling the competing behaviors of interacting agents. Here a "game" means the study of strategic interactions among people. Its reach covers auctions, bargaining, mergers and acquisitions pricing, fair division, duopolies, mechanism design, and voting systems, spanning experimental, behavioral, and information economics.

  Information economics studies how information and information systems shape an economy and its decisions. Information has special traits: easy to create but hard to trust, easy to spread but hard to control. By loosening the assumption that agents have complete information, economists can examine action under uncertainty. Interest has grown recently, possibly tied to the rise of information-based companies in the technology industry.

  Microeconomics is also known as price theory, a name that stresses how buyers and sellers set prices through their own actions. Price theory is associated with the Chicago School of Economics and uses less game theory than microeconomics does, focusing on competition rather than strategic behavior. Its framework has reached fields once thought outside economics, including criminal justice, marriage, and addiction.

  Applied microeconomics fans out into specialized areas. Labor economics studies labor markets alongside immigration, minimum wages, and inequality. Health economics examines health care systems and insurance programs. Urban economics confronts sprawl, pollution, traffic congestion, and poverty. Financial economics, law and economics, public economics, and industrial organization each carry microeconomic principles into a corner of the world that prices quietly govern.